Monday, April 14, 2008

Secrets of the Fed 

I had just finished writing a chapter on central bank independence when Bill Greider's Secrets of the Temple came out. People were shocked, shocked, to find out that Paul Volcker was running the economy. Volcker was a secret because, well, he decided to avoid publicity (even the Volcker report on corruption in the UN didn't do much for his visibility.) Having a visible central banker might draw attention to its status, I thought at the time. At that particular point, central banks were still musty old places thought about mostly by people who worked in them and a few Fed-watchers and other academics.

Now in that very same year -- as I was reminded yesterday, taking a walk and listening to an Econtalk podcast with Tyler Cowen -- New Zealand was fed up with its experience of high inflation. It had had what was the norm: A central bank that answered to its government, not subject to much outside scrutiny, designed to support that government in many ways. Through the 1980s it had an inflation rate greater than 10% per year on average. So it hires a governor for its Reserve Bank named Don Brash and says "get the inflation rate down to 2% and keep it there, or you're fired." Brash does the job until 2002 when he decides to go into politics. (I know very little about NZ politics, but it appears his run as RBNZ governor has been overshadowed by his political career, not necessarily for the better.)

As Cowen notes, people begin to look at New Zealand as an example and emulate it. The idea that central banks should be independent -- temples where the monks chant behind an icon wall -- gained hold. We monetary economists begin to talk about inflation targeting. And one by one, central banks begin to change. Whereas in 1989 there were only three central banks generally agreed to be independent -- the Bundesbank in West Germany, the Swiss National Bank, and the Fed -- there are now many more, leaving the Fed almost a laggard behind its ECB brethren.

Important to note, as I did in a forthcoming paper, is that where the New Zealand model was adopted you could not call those central banks independent. They have a contract with the government.

So what's better, a central bank that runs itself without accountability to the government but without any inflation bias, or a central bank that's dependent but with a contract that makes inflating the economy costly to both? I wondered that reading Robert Reich's rediscovery of the secrets of the Fed:
Five years ago the Fed decided to make money so cheap lenders shoved it out the door to anyone capable of standing up, and Alan Greenspan pooh-poohed the idea that regulators should be especially vigilant. What happened? We had a housing bubble, millions of Americans are losing their homes, tens of millions are watching their major asset (their home) drop in value and their pensions shrink.

So does this mean the Fed should be more accountable? Are its decisions so important that citizens have a right to more say in what it does? Problem is, most people don't understand what it does, and have no idea how it makes decisions. And partisan politics could do terrible damage. Yet we don't want the Fed to refrain from doing what it's doing. Paul Volcker to the contrary notwithstanding, government has to make sure there aren't runs on our banks and that our financial system is strong.

The first step in reconciling democracy with the Fed is for people to become better educated about it. Most Americans don�t even know where the Fed is located. (It�s on 20th Street and Constitution Avenue in Washington.) And most have no idea who runs it. (Besides the chair, now Ben Bernanke, are openings for six other members of the board of governors, each appointed for fourteen years. Five regional bank presidents join them on the Open Market Committee. Who appoints the regional bank presidents? If you don�t know, you ought to find out.) These twelve people have more power over your daily life than your congressman and Senator, maybe even your president.
Jim Hamilton wonders whether we have allowed the Fed too much leeway with the new lending facilities they have, which implicitly put the taxpayer at risk of holding some really lousy securities in return for the Treasuries the Fed is lending. And Volcker himself is suggesting the current occupant is dancing on the edge of the Fed's legal authority.

I don't know where the legal limit on what the Fed can do with its portfolio is or whether the Congress can order him to stop. But the Fed is a creation of Congress and, if Congress wanted the Fed not to make these alphabet-soup lending facilities, it could just introduce a bill to stop it. One thing to note is that when Cukierman, Webb and Neyapti coded central bank structures in deciding which ones might be more independent than others, there was a code for the width of borrowers that could borrow from the central bank. The Fed was shown to have the most narrow circle of borrowers -- only the federal government. But there are no limits on how much, or at what interest rate, or whether the Fed could lend in primary markets, who decided terms, etc. If the Fed now chooses to widen the circle of borrowers, there are many other types of controls that could be in place but which were never considered as I understand and remember the Fed's history. What Volcker and Hamilton would seem to assert is that the narrow circle is important for keeping a structure of the Fed that has independence. If that circle is to be widened, other changes to the Federal Reserve Act may be considered.

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